[This article about physician retirement ran as one of my monthly columns from MDMag.com. It starts with the depressing news that a safe withdrawal rate is far lower than most investing novices think, and that returns must be adjusted for inflation.  It finishes with the good news that most doctors need to replace far less of their pre-retirement income than they might think to have a comfortable retirement.]

When it comes to planning for retirement, there are three concepts that physician investors often misunderstand. Unfortunately, two of these three constitute “bad news” that I hate to deliver to the “patient.”

However, just like in medicine, you have to understand the bad news to plan your life and treatment plans appropriately.

The Bad News for Physician Retirement

The 4% rule

As an investor begins learning about investing for retirement, one of the first concepts she comes in to contact with is the idea of a “safe withdrawal rate” (SWR). This is a percentage of her initial portfolio, indexed to inflation, that she can withdraw each year with a very low chance of running out of money in retirement. Many investors (and their advisors) thought this number was as high as 6%, 8% or, even, 10% before they were disabused of this notion by a study out of Trinity University first published in the 1990s. The most important table from the Trinity Study is Table 2, reproduced below with data updated through 2009.

As you can see, if you want your portfolio to last 30 years, you can’t withdraw 10% of it a year. You can’t even withdraw 6% from a typical 50/50 portfolio and expect it to have better than a 50% chance of lasting 30 years. Experts like to argue about whether the SWR is 3% or 4% or even 4.5%, but that wasn’t really the point of the Trinity Study. The point was that the SWR isn’t 8%.

The implications of this fact are that on the eve of retirement you need a portfolio approximately 25 times as large as your desired annual income from the portfolio. This is far more money than most beginning investors generally think they will need. A million dollars seems like a lot of money, until you realize a portfolio that size can really only support an income of $40,000 per year.

For a physician who has been making $200,000, $300,000 or, even, $400,000 per year, the thought of living on only $40,000 might be downright depressing. If a physician wanted to replace his entire $200,000 income, he would need a $5 million portfolio. In order to achieve that over a 30-year career with a 5% annualized return he would need to put $73,000 per year toward retirement, or nearly 37% of his income! If he wanted to retire early after 20 years of practice, that number rises to 72% of his income — a nearly impossible figure.

This is bad news indeed.

Returns Must be Inflation Adjusted

To make matters worse, many novice investors use nominal return figures when making calculations. While that is probably fine for short time periods, if you are making plans that span several decades (like retirement planning) inflation must be taken into account.

Historically, inflation has averaged around 3% per year. At that rate, $1 million worth of purchasing power today will require $2.4 million in 30 years. If you decided you needed a $2 million portfolio in today’s money to retire in 30 years, and estimated your portfolio would earn 8% annualized returns, you might make the erroneous assumption that you only need to save $17,000 per year. However, if you properly take inflation into account, you would adjust that return down for inflation, perhaps to 5%, and realize you actually need to save $29,000 per year.

The Good News

You Need to Replace Much Less of Your Income Than You Thought

If this is the first time you’ve read about the concept of an SWR and the perils of inflation, you might be reaching for the Prozac. Hold off for just a minute while I share one of the few pieces of good news out there for physicians planning for retirement.

Many physicians mistakenly assume they’ll need to replace their entire income with their portfolio. Even if they ask a financial advisor for a rule of thumb, they might be told they will need 70% to 80% of their pre-retirement income in order to comfortably retire. The truth is that the vast majority of doctors will need a MUCH lower percentage of their pre-retirement income in order to retire comfortably.

For a typical physician who plans well for retirement, his expenses will decrease dramatically by the time he retires. Consider all the expenses you’re paying now that you won’t be paying in retirement:

Now, everyone’s situation is a little different, and a few expenses may even go up (such as greens fees, travel expenses and health care costs), but these pale in comparison to the “biggies” such as a mortgage, the high tax burden most doctors pay and retirement savings.

Most physicians who go through this exercise will realize they probably only need 20% to 50% of their pre-retirement income in order to have a very comfortable retirement. Things look even nicer once Social Security is taken into account. While Social Security will replace a much lower percentage of a physician’s pre-retirement income compared to a lower earner, a typical doctor can still expect it to replace about 10% of his pre-retirement earnings.

If you put all this together, a physician now earning $300,000 may find that he will have a very comfortable retirement if his portfolio will provide an income of just $100,000. He can achieve this by saving a very reasonable 15% of his income every year for 30 years and earning a 4% after-inflation return on that savings.

A comfortable retirement is within reach for any physician willing to start early, to learn a little about investing, and to be disciplined about saving a reasonable portion of his income each year.